Have you ever thought about how financial markets work? It may be helpful, as we begin to think about this question, to consider how markets work in other areas of business. People trust markets every day. For example, when we go to the grocery store to buy oranges, we see the current market price per pound. We usually don’t question whether the price is “right” or ‘wrong’. We normally assume the price reflects local market conditions and we accept the price as fair. We may decide the price for the oranges is too much and not make the purchase. If enough of us feel the same way, then the grocery store will lower the price to sell its oranges. That is how markets work.
When it comes to financial markets, people’s perception of how markets work often breaks down because they assume the price of a stock or bond may not be correct. If we assume the price of a stock is not correct, then we have to predict, or forecast, what the correct price should be. The prices that the market produces are based on the opinions and expectations of many, many, highly skilled, highly motivated well-informed experts who trade stocks and bonds on a frequent basis. This results in financial markets that are an effective information-processing machine, and the real time information brought by buyers and sellers helps set prices. The collective estimates of price by so many traders usually produce an accurate price.
So the question arises, how often are professional stock pickers with mutual fund companies able to beat the market itself? Not very often. According to the CRSP Survivor-Bias Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago, for the 15 year period ending on December 31, 2014, of the U.S. mutual funds investing in equities, only 19% of the mangers who tried to outsmart other participants through stock picking or market timing were able to outperform their benchmarks.
We avoid trying to outguess the market or chase past performance by letting the markets work for us by investing in low cost asset class funds across different asset classes. Having different asset classes mixed together in a portfolio also generally reduces risks. While we certainly can’t predict the future, history has taught us that the financial markets have rewarded long-term investors.